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Fed Leads Drive to Strengthen Bank System

A day after the Federal Reserve disappointed investors with a modest cut in interest rates, central banks in North America and Europe announced on Wednesday the most aggressive infusion of capital into the banking system since the terrorist attacks of September 2001.

Stocks initially surged around the world when the coordinated move was announced by the central banks, though markets in the United States gave up nearly all those early gains in afternoon trading. The action is being led by the Fed, which this month will lend $64 billion itself and through banks in Europe, and includes the backing of the Bank of Canada, the European Central Bank, the Bank of England and the Swiss National Bank.

The injection of new capital into the market suggests that policy makers are increasingly concerned about the stability of the credit markets, which have seized up again in the last couple of weeks after they overcame an earlier bout of panic in August and September. Economists and market specialists say policy makers are trying to reassure bankers that they will stand firm as the lender of last resort.

“This is basically a reinsurance policy, it’s not an insurance policy,” said William H. Gross, the chief investment officer of Pimco, the bond-management firm. “They are saying, ‘We will stand behind you.’ ”

Fed officials said the move was an effort to improve financial markets, not a response to problems at specific banks. “This is not about particular financial institutions with particular problems,” a senior Fed official told reporters in a background briefing. “It is about market functioning.”

Economists and market specialists generally welcomed the Fed’s intervention but expressed some skepticism whether it would be enough to allay the biggest problems in the credit markets related to problems in the American housing market, where home prices continue to fall and mortgage securities are plagued by rising defaults and foreclosures.

“They do not address the underlying imbalances threatening the world economy — notably the impact the U.S. housing slump will still have via conventional economic channels,” said Julian Jessop, chief international economist at Capital Economics in London. “But they should at least reduce the risk that the credit crunch tips economies into recession.”

When markets are functioning properly, banks easily and regularly borrow money from each other at rates that are slightly higher than what, say, the American government borrows at through Treasury bills. The banks are acting like homeowners who borrow against the value of their homes, but in the banks’ case they are putting up securities they own as collateral.

But with markets increasingly uncertain about the quality of bank’s holdings — the home loans in their mortgage securities are defaulting at a high rate, for instance — lending between banks has slowed and become much more expensive.

The difference between what banks pay to borrow and what the Treasury pays, for instance, has jumped from less than half a percentage point to more than 2.2 points on Tuesday. By stepping into the breach and lending directly to banks, policy makers are hoping to tamp that premium back down.

At its meeting Tuesday, the Fed lowered its target for the federal funds rate, the rate banks normally pay on loans to each other, to 4.25 percent. And it lowered the discount rate, the rate at which the Fed will lend to banks on loans secured by virtually any collateral, to 4.75 percent. Share prices fell after that announcement amid disappointment that a larger cut was not made. They recovered their losses Wednesday during some wide swings.

The Standard & Poor’s 500-stock index, which gained more than 2 percent at one point in the morning, was down 0.3 percent late in the day and then ended up 8.94 points, or 0.6 percent, at 1,486.59. The Dow Jones industrial average climbed nearly 270 points early on, then reversed course and was down more than 110 points. It finished up 41.13 points, or 0.3 percent, at 13,473.90.

Fed officials said the announcement had been in the works for some time, but could not be announced Tuesday because the central banks wanted to make the announcement when all their markets were open.

“Market reaction yesterday had nothing to do with today’s announcement,” said a senior Fed official. “This was a global effort among a number of central banks. We wanted to announce that together. We couldn’t have announced that yesterday as Europe was closed” when the Fed announced its action.

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The Fed also said it was making available funds to allow the European Central Bank to lend $20 billion and the Swiss National Bank to lend $4 billion to European banks that needed to borrow dollars.

The first auction of $20 billion was scheduled for next Monday, followed by another auction of $20 billion on Dec. 20. The third and fourth auctions will be on Jan. 14 and 28.

The Fed said that the new auction process should “help promote the efficient dissemination of liquidity” when other lines of credit were “under stress.”

The experience gained from the four scheduled auctions would be “helpful in assessing the potential usefulness” of this new process to provide funds to banks in the United States, the central bank said.

Since the global credit crunch hit with force in August, central banks as well as the Federal Reserve have been injecting large amounts of money into the banking system in an effort to keep credit flowing. Nonetheless, loans have been hard for many to obtain.

The auctions held by the Fed will set interest rates on borrowings by banks from the Fed. The banks will be able to post a wide range of collateral, including illiquid securities like collateralized debt obligations, as they now can do at the discount window. But while it often becomes known which banks borrow at the discount window, the auction procedures are intended to keep the identities of the borrowers secret.

He said the bank hoped to reduce the difference between overnight loan rates and those for three-month and six-month periods, which have remained stubbornly elevated as banks and other financial institutions have stepped up their cash hoarding toward the end of the year.

After relaxing somewhat in September and October following great turmoil in late summer, credit markets have grown tense since mid-November.

Demand for credit often runs higher toward the end of the year, but this year banks are also building up liquidity cushions to guard against further losses linked to the deteriorating mortgage market in the United States.

“The most positive aspect is that this is a new response to a problem that seemed to remain intractable,” said Marco Annunziata, the London-based chief economist for UniCredit. “It will probably not be the silver bullet, but it should allow us to move forward.”